BREAK-EVEN ANALYSIS

Break-even analysis is used in cost accounting and capital budgeting to
evaluate projects or product lines in terms of their volume and
profitability relationship. At its simplest, the tool is used as its name
suggests: to determine the volume at which a company's costs will
exactly equal its revenues, therefore resulting in net income of zero, or
the "break-even" point. Perhaps more useful than this simple
determination, however, is the understanding gained through such analysis
of the variable and fixed nature of certain costs. Break-even analysis
forces the small business owner to research, quantify, and categorize the
company's costs into fixed and variable groups.

"Understanding what it takes to break even is critical to making
any business profitable," Kevin D. Thompson stated in
Black Enterprise.
"Incorporating accurate and thorough break-even analysis as a
routine part of your financial planning will keep you abreast of how your
business is really faring. Determining how much business is needed to keep
the door open will help improve your cash-flow management and your bottom
line."

The basic formula for break-even analysis is as follows:

BEQ FC /(P-VC)

Where BEQ Break-even quantity

FC Total fixed costs

P Average price per unit, and

VC Variable costs per unit.

Fixed costs include rent, equipment leases, insurance, interest on
borrowed funds, and administrative salaries—costs that do not tend
to vary based on sales volume. Variable costs, on the other hand, include
direct labor, raw materials, sales commissions, and delivery
expenses—costs that tend to fluctuate with the level of sales. A
key component of break-even analysis is the contribution margin, which can
be defined as a product or service's price (P) minus variable costs
(VC) per unit sold. The contribution margin concept is grounded in
incremental or marginal analysis; its focus is the extra revenue and costs
that will be incurred with the next additional unit.

The first step in determining the level of sales needed for a small
business to break even is to compute the contribution margin, by
subtracting the variable costs per unit from the selling price. For
example, if P is $30 and VC are $20, the contribution margin is $10. The
next step is to divide the total annual fixed costs by the contribution
margin. For example, a company with FC of $50,000 and a contribution
margin of $10 would need to sell 5,000 units to break even. This number
can easily be converted to the dollars of revenue the company would need
to break even for the year. Simply multiply the break-even point in units
by the average selling price per unit. In this case, a BEQ of 5,000 units
multiplied by a P of $30 per unit yields break-even revenue of $150,000.

Break-even analysis has numerous potential applications for small
businesses. For example, it can help managers assess the effect of
changing prices, sales volume, and costs on profits. It can also help
small business owners make decisions regarding whether to expand their
operations or hire new employees. Break-even analysis would also be useful
in the following situation: a small business owner is skeptical of her
marketing manager's projection for sales of 15,000 units of a new
product, and wants to know what minimum quantity of units must be sold to
avoid losing money, assuming a selling price of $25, fixed costs of
$100,000, and variable costs of $15. The equation tells her that these
parameters will require a break-even volume of 10,000 units; fewer than
that level yields losses, more than that level yields profits. This
perspective of analysis may be employed where the analyst is highly
confident of the estimates for price and costs, but feels less certain
about the assessment of market demand. In this case, the small business
owner might be interested in how low sales could fall below the marketing
manager's forecast without causing an embarrassment at year-end
reporting time.

Another scenario may involve the question of how to manufacture a product,
in terms of the nature of operations and how they will affect fixed costs.
Here, a small business owner may have a good handle on the quantity
expected, the likely selling price, and the variable costs involved, but
be undecided about how to structure the new operation. If the volume is
expected to be 10,000 units, at a selling price of $5 and variable costs
of $3.50, the break-even equation tells him that fixed costs can be no
greater than $15,000. "The bottom line is that, especially for
small businesses, the margins for error are much too narrow to make
business decisions on gut instinct alone," Thompson concluded.
"Every idea, whether it is the introduction of a new product line,
the opening of branch offices, or the hiring of additional staff, must be
tested through basic business analysis."